Query regarding backwardation

[varun]

Query regarding backwardation

[Anonymous]

Can someone ans this for me along with explanation please:

In the commodity markets, being long the future and short the cash exposes you to which of the following risks?

Increasing backwardation
Increasing contango
Change in volatility of the commodity
Decreasing convexity

Thanks in advance

[Anonymous]

In my opinion (and please get the expert to verify these answers)

(1) Increasing backwardation — Backwardation is a phenomenon whereby the future price of commodity is lower than its spot price. This is due to a positive convenience yield. If you are long in the future and backwardation increases then you would lose in the “mark to market” and therefore (1) is a risk.

(2) Increasing contango – Contango is opposite of backwardation and is therefore not a risk.

(3) Change in volatility of the commodity – Volatility can affect prices, productions and inventories and can therefore change the price of the commodity. I would classify this as a risk but unless more information is provided we don’t know what the affect might be. Have a look at this paper on volatility and price dynamics of a commodity: http://web.mit.edu/rpindyck/www/Papers/Volatility_Comm_Price.pdf

(4) Decreasing Convexity – I am not sure about the relationship of convexity and commodity price. Normally, you associate convexity with an instrument, like bond, that pays coupon. Unless there is some other interpretation of convexity, I would be inclined to say this is not a risk simply because I can’t see the dynamics of convexity in a commodities market.

[Anonymous]

Thanks for the reply, even I had the same interpretation regardgin options 1 and 2, though was not sure about 3,4.I think this makes sense.Thanks very much.

[Author]

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